An upward movement in the long-term yield curve due to acceleration in inflation for May and June may impact the profitability of banks, as per a report.
A 100 basis points (bps) upward shift in the bond yield curve could impact the pre-provisioning operating profit (PPOP) of the overall banking system by 5.8 per cent, India Ratings said in the report.
The PPOP of public sector banks (PSBs) may be impacted by 8 per cent and that of private banks by 3.2 per cent, it added.
"As the inflation data for May and June 2021 breaches the Reserve Bank of India's (RBI) target corridor, it could exert pressure on the long-term yield curve. Our analysis shows that this could have a significant impact on the profitability of the Indian banking system," the agency said.
The inflation mandate requires the RBI to keep inflation at 4 per cent, with the upper tolerance level of 6 per cent and the lower tolerance level of 2 per cent.
The consumer price-based inflation (CPI) or retail inflation slipped to 6.26 per cent in June 2021 from 6.3 per cent in May 2021.
The agency said the 100 bps movement in the yield curve would impact the common equity tier 1 of PSBs by 28 bps and that of private banks by 13 bps, while for the overall banking system, the impact could be 22 bps year-on-year.
This has been taken on a post-tax basis, without considering the banks' ability to reclassify their trading book and a likely partial offset from lower pension costs, it added.
On analysing the past interest rate cycles, the agency said it has observed there have been three cycles of a yield curve expansion FY2005 onwards, showing a strong inverse correlation between treasury income and interest rate movement.
The sensitivity seen for PSBs was much higher than that for private banks, it noted.
During the first cycle, treasury income contribution to PPOP reduced to 3.4 per cent in FY2007 from 21.3 per cent in FY2005, while it reduced to 3.2 per cent in FY12 from 15.3 per cent in FY2010 in the second cycle and to 5.6 per cent in FY19 from 22.5 per cent in FY18 during the third cycle.
Also, the sensitivity was similar for private banks. However, the volatility in PPOP and PAT was limited due to a lower share of the trading book than that for PSBs till FY2014 and stronger operating profit buffers, the report said.
Nonetheless, private banks were also impacted in the FY18-19 cycle during which the treasury income fell to 3.3 per cent from 9.7 per cent of PPOP and to 9.3 per cent from 25.8 per cent of PAT, it added.
The expansion in treasury contribution to PPOP and PAT was visible post-September 2018, where the yield curve peaked and PSBs' treasury contribution to PPOP increased to 16 per cent in FY21 from 5.6 per cent in FY19, the agency said.
Even at the PAT level, PSBs' losses were minimised in FY19 and FY20 with gains from treasury income.
Furthermore, even with the improvement in operating profit buffers in FY21, 98.5 per cent of PAT came from treasury gains.
Similarly, private banks' treasury contribution to PPOP and PAT increased significantly to 12.5 per cent from 3.3 per cent and to 31.3 per cent from 9.3 per cent, respectively, during FY19-21, it said.